5 key investment principles
Before you start investing, it pays to learn the basic principles. The more you know, the better off you’ll be in the long run.
There are 5 key principles to think about when investing, which will help reduce your risk and build your wealth. You should also remember that your investment strategy depends on your attitude to risk, your financial situation and life goals. If you’re unsure of what these are, you should speak to a financial planner.
So what are the 5 key investment principles?
- Start early, invest regularly and reinvest distributions
- Set your investment goals and pay yourself first
- Diversify
- It’s time in the market not market timing
- Invest for the long term – the trade off between risk and return
1. Start early, invest regularly and reinvest distributions
The earlier you start investing, the more opportunity your investment has to grow through compounding – which means you generate earnings on earlier earnings.
Investing regularly also helps to smooth out the costs of investing in rising and falling markets. Let’s see how this works in practice:.
Jane puts away $100 a month, every month from the day she turns 20 to the day until the day she turns 30, making no withdrawals. By the time she reaches 60, her investment will be worth $962,952. For simplicity's sake, we'll assume that both Jane and Belinda earn 6% each year on their investments.
Belinda puts away $100 every month, but she doesn’t start until she’s 30. Instead of investing for 10 years, Belinda invests until she’s 50 (twice as long as Jane). By the time she reaches 60, her investment is worth $837,960. So despite the fact that’s she’s put away twice as much, her investment is worth slightly less.
Why? Compound interest has given Jane a massive head start. By age 60, Jane’s investment has been compounding for 40 years, while Belinda’s has only been compounding for 30 years. As you can see, that extra 10 years makes a huge difference.
What can we do to get us where we want to be financially?
- We can put away more each month.
- We can save for longer.
- We can reinvest our earnings
- We can try to make our money work harder for us.
2. Set your investment goals
To invest successfully, you need to establish investment goals. Having a clear understanding of your goals will help you select the most appropriate investments to achieve them.
To help you assess your current financial situation, and therefore how much you can afford to invest, you should prepare a current budget. This will help you determine how much you can afford to invest.
Once you have decided on the right type of investment for you, a tried and tested way to stick to your regular investment plan and achieve your goals sooner is to have this investment amount automatically deducted from your pay.
A financial planner can help you through the process of preparing a financial plan, including goals, budget, risk profile and timeframe, as well as recommending a range of investment strategies tailored to your situation.
3. Diversification
Diversification is one of the keys to successful investing. Do you want to have all of your eggs in one basket, or do you want a few baskets?
Simply put, diversification is about lowering the level of risk across your investment portfolio by spreading your investment across a number of assets. In a way, it has a smoothing effect – you won’t get the huge gains, but nor should you experience the big losses.
4. Timing the market versus time in the market
'Timing the market' is where you try to buy when the market is low and sell when it is high. However, anticipating the top and bottom of the market can be extremely difficult. In practice, many who try to time the market end up worse off.
'Time in the market' refers to the length of time your investment stays in the market. Adopting a longer-term approach to the market often results in less volatility in the performance.
5. Invest for the long term – the trade off between risk and return
All investments involve some degree of risk. Investments with the highest potential returns tend to also have the highest risk. So, not only may your returns vary, but the value of your investment can fall.
Regardless of the type of investment option you choose, it may not perform according to your expectations. You need to strike a comfortable balance between the level of risk you are prepared to accept and your desired level of return. As a general rule, the longer the timeframe you can invest for, the more risk you can afford to take.
The diagram below shows the trade off between risk and return. You should keep this in mind when thinking about your investor profile and your investor goals. You can find out your investor profile here.
